These are the biggest mistakes the Fed made in 2008

Chairman of the Federal Reserve Ben Bernanke testifies before Congress' Joint Economic Committee on Capitol Hill in Washington March 28, 2007 REUTERS/Kevin Lamarque David Beckworth on the Fed's 2008 mistake:

Again, the Fed tightening in 2008 was not just about the absence of a 2% interest rate cut. It was about an expectation that the Fed was going to raise rates going forward, even though the economy was weakening. This development was huge because current spending decisions are shaped more by the expected path of interest rates than by current interest rates.

So why did the public expect this tightening? Because the Fed was signalling it! Among other places, this signalling was clear in the August and September 2008 FOMC statements. Here is a gem from the August FOMC meeting (my bold):

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.

And from the September FOMC meeting we get a similar warning:

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.

This was forward guidance at its worst and points to a far more intense tightening cycle than is apparent by looking only at the current policy interest rate. The Fed was willing to strangle the already weak economy over inflation concerns and the market knew it. It was this severe tightening of monetary policy that turned an otherwise ordinary recession into the Great Recession.

As I noted before, this tightening of policy occurred before the worst part of the financial crisis in late 2008. Recall that many of the CDOs and MBS were not subprime, but when the market panicked in late 2008 a liquidity crisis became a solvency crisis for all. Had the Fed not tightened during the second half of 2008 the financial panic probably would have been far less severe and the resulting bankruptcies far fewer. So no, it is not obvious that a severe financial crisis was inevitable.

This whole issue is coming up again because Ted Cruz asked Fed boss Janet Yellen about it a recent hearing. Whether Cruz was just looking for a fresh anti-Fed attack line or is signalling his intellectual evolution into being a market monetarist, I don't know. But either way I am glad the issue has resurfaced to provide some guidance during the next economic downturn.

The Fed has a macro role to play when there is an economic shock. It would be great if both parties understood that role, providing a third option other than fiscal stimulus and "let it burn" austerity.